Speeches and Testimonies

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October 26, 2001



"Self-Regulation: How It Can Assist Regulators"

Opening Remarks Good afternoon. As you can see, I am not Bob Wilmouth, the person originally scheduled to speak to you this afternoon. Bob is Rome today, speaking to members of the International Organization of Securities Commissions regarding the issue of trading halts and how they affect cross-border securities and derivatives trading. Bob's participation at the IOSCO meeting is an excellent example of the subject of my talk here today: "How Self-Regulation can Assist Regulators". I'll have more examples a little bit later.

My name is Karen Wuertz and I am the senior vice president of Strategic Planning and Communications for National Futures Association.

I think Bob had three reasons for asking me to speak in his behalf today. First, I have worked at NFA for several years and have first-hand knowledge of the strong working relationship between NFA and its statutory regulator, the Commodity Futures Trading Commission. NFA has enjoyed great success as the self-regulatory organization for the United States futures industry over the past 19 years and has served as a resource and self-regulatory model for emerging markets around the world.

In fact, I would like to take this opportunity to invite you to visit NFA and discuss how self-regulation would benefit your particular regulatory framework. We are always happy to provide any information or assistance you may need.

Second, I served for two years on a subcommittee designated by the SRO Consultative Committee of IOSCO. This subcommittee was charged with preparing a paper advocating the use, value and efficiencies of self-regulation as part of the overall regulatory structure in the financial services industry. The subcommittee included a cross-section of self-regulatory organizations from various international locations and types of financial markets. Preparing the paper was a two-year process, involving surveys and interviews with financial experts from around the globe. I was honored to present the paper at IOSCO's annual meeting in Sydney, Australia, in May of last year.

By the way, we have included a copy of that paper in your materials this afternoon.

I have also conducted training sessions in Singapore, participated in IOSCO training in Montreal, and I attend international regulatory workshops several times a year.

Oh, and the third reason Bob asked me to speak to you today? He knew I wouldn't say "no".

Brief History of NFA
I realize there might be some of you here who may not be familiar with NFA, so I'd like to take a couple of minutes to give you a brief history of the Association. Actually, the story of NFA's formation and its accomplishments is a textbook example of "How Self-Regulation Can Assist Regulators."

In the early 1970s, a series of economic events dramatically changed the U.S. futures industry. Global demand for agricultural products grew while supplies dwindled, resulting in volatile price fluctuations on agricultural futures contracts. Futures exchanges also began introducing contracts on commodities such as metals, lumber and currencies. All of this activity attracted new and largely unregulated participants to the industry. Soon customer losses due to firm insolvencies and unethical business practices increased and the industry's reputation was threatened.

Recognizing a need for additional regulation, the U.S. Congress enacted legislation in 1974 that established the CFTC as an independent federal regulatory agency with jurisdiction over futures trading. The legislation also authorized the creation by the futures industry of "registered futures associations", giving the industry the opportunity to develop a self-regulatory organization that would work in conjunction with government oversight.

Industry leaders formed an Organizing Committee and began working closely with congressional leaders, CFTC officials, and futures firms and exchanges to construct an organization that would strengthen the reputation of the markets by establishing and enforcing high standards of business activity. When NFA officially began operations on October 1, 1982, its mission was clearly defined: protect the public investor by maintaining the integrity of the marketplace.

And that's exactly what we have been doing for the past 19 years. Our relationship with the CFTC has grown and strengthened through the years. We have taken on additional responsibilities and provided the futures industry with innovative and cost-effective regulatory programs and services. The results of this regulatory partnership speak for themselves. Since NFA began operations, trading volume has increased by 284 percent while customer complaints have actually dropped by 72 percent. Clearly, there are many benefits that can be achieved when self-regulators and regulators work together.

Defining Self-Regulation
To best describe how self-regulation and regulators can form a dynamic partnership to benefit the financial services industry, I would like to begin by giving you a brief definition of self-regulation. Then I'll spend a few minutes outlining specific elements of self-regulation and how those elements can help regulators achieve their objectives.

Self-regulation has a long and successful history in the financial services industry. In fact, in several jurisdictions around the world, effective self-regulation existed before statutory regulation. As markets developed, market participants recognized that regulation was necessary in order to protect the integrity of the market. However, industry participants also recognized that those who were most familiar with the customs and practices of a particular trade were best suited to create rules related to that trade. They were also best suited to enforce those results and to resolve the disputes that arose from those rules.

Many different forms of self-regulation currently exist. There are industry self-regulatory organizations, exchange self-regulatory frameworks and private associations that define and encourage adherence to standards of best practice among its participants. Self-regulation typically focuses on oversight of the market itself, qualification standards for market intermediation and oversight of the business conduct of intermediaries, including their relationship with their client market-users.

Effective self-regulation must also be defined within the context of government oversight. In fact, government oversight is an essential element in the self-regulatory structure because it ensures that all interests are given the proper consideration and voice in all regulatory activities. It provides the proper system of checks and balances and avoids potential conflicts of interest. It's important, however, that the government's regulatory framework provide an appropriate level of government oversight of SRO activities without encumbering or usurping an SRO's ability to respond quickly and flexibly to changing market conditions and business needs.

Effective Rule-Making
Self-regulation has proven to be efficient regulation, and there are many reasons for its success. I would now like to spend a few minutes discussing specific elements of self-regulation and how those elements can complement the work of statutory regulators. I'd like to focus on four major elements of self-regulation: industry knowledge and representation, industry motivation, flexibility, and coordination and information sharing.

Financial markets are becoming more and more complex. If you don't believe me, just ask some of the people in this room who have been involved in the development of rules and regulations regarding the introduction of the new security futures products. In an environment characterized by a variety of different markets, products and participants, the specialized and thorough knowledge provided by self-regulators is very beneficial. It allows the self-regulatory organization to design, implement and evaluate effective compliance programs.

For example, at NFA we have three Advisory Committees, made up of representatives of Futures Commission Merchants, Introducing Brokers, Commodity Pool Operators and Commodity Trading Advisors. An integral part of our rule-making process involves discussions with each of these committees. Their practical experience and industry knowledge provide insight and guidance that are essential for creating rules that are perceived as appropriate and reasonable by the regulated firms and individuals.

This same industry knowledge is also an invaluable source of expertise for the statutory regulators. On numerous occasions, the CFTC has worked closely with NFA to turn a conceptual idea for a rule into an effective, workable rule that meets regulatory objectives. This productive exchange of ideas between a statutory regulator and knowledgeable industry participants speaking through their self-regulatory organization provides rules and regulations that more accurately reflect the realities of the marketplace.

Hand in hand with industry knowledge is industry representation. Both statutory regulators and SROs recognize that industry representation provides each regulator the capacity to react quickly to changes in the marketplace. Whether it's additional data regarding industry issues or possible solutions to a complex problem, industry representatives provide the input necessary for effective regulation.

As you can see, one benefit of the partnership between SROs and their statutory regulators is a stronger, more effective rule-making and enforcement framework. The statutory regulator's rules are supplemented and enforced by those entities directly involved in the regulated activity.

Cost Efficiencies
The second element of effective self-regulation is industry motivation. Self-policing systems and the general concept of self-regulation work because of the business incentive to operate a fair, financially sound and competitive marketplace. Reputation and competition are powerful motivating forces for sustained proper behavior, especially in today's global environment where participants have virtually immediate, 24-hour access to a range of competing markets and products.

One way an industry can demonstrate its commitment to self-regulation is by demonstrating its willingness to pay for self-regulation. In the United States, for example, NFA is funded entirely by the futures industry. No federal, state or city taxes are used to finance the Association.

Which leads me to a second benefit that self-regulation can provide to statutory regulators: cost efficiencies. As an SRO establishes itself within the industry and demonstrates its effectiveness to the marketplace, the statutory regulator may find opportunities to delegate some of its responsibilities to the SRO. This allows the regulator to use its own resources more effectively.

We have seen many examples of this benefit during NFA's 19-year history. Early in our history, the CFTC named NFA the sole custodian of all the registration records, and all CFTC registrations are currently processed and stored by NFA. The assumption of these and other responsibilities resulted in savings of millions of dollars.

During the early 1990s, NFA indicated to the CFTC its interest in assuming additional responsibilities, including Disclosure Document review. At that time, Commodity Pool Operators and Commodity Trading Advisors were required to submit their Disclosure Documents to both NFA and the CFTC. In 1997, NFA submitted a proposal to the CFTC outlining the Association's Disclosure Document review process. The proposal was approved and on November 1, 1997, NFA assumed sole responsibility for this important regulatory function.

These are just two examples of how a strong regulatory partnership can distribute regulatory duties in a way that is not only more cost-effective but also more efficient.

A third element of self-regulation I'd like to discuss with you today is flexibility. Self-regulation allows market participants to respond to inevitable change in an innovative, timely and sensitive manner. The experience and expertise that I mentioned earlier gives self-regulatory bodies the ability to modify their rules in response to changes taking place in the industry more readily than government agencies that may be restricted by their legislative framework. In many jurisdictions, the more rigid requirements typically imposed on the rule making process of statutory regulators does not allow them to react as quickly to changes taking place in the financial services industry.

I must point out, however, that the CFTC has taken significant steps during the past year to remedy this problem. It is moving from a more rigid regulatory framework to one that defines the CFTC as an oversight agency, replacing many of its specific rules with a series of best practices guidelines. This new regulatory framework will benefit not only the agency itself, through better use of its resources, but the entire futures industry.

Coordination and Information Sharing
The fourth and final element of self-regulation that I want to discuss with you today is the element of coordination and information sharing. Obviously, as markets become more global, coordination of market oversight becomes more important. Information sharing must be a priority among markets in order to address cross-market issues.

SROs are an excellent forum for bringing together different interests on regulatory issues. Fortunately, the development of advanced communication technologies will continue to improve the quality, amount and timeliness of shared information. One example of information sharing that NFA is particularly proud of is our own Background Affiliation Status Information Center, or BASIC. BASIC is a web-based system that allows anyone with access to the Internet the opportunity to research the registration and background information of every firm and individual conducting business in the United States futures industry. Developed in conjunction with the CFTC and the U.S. futures exchanges, BASIC contains a remarkable depth of information, including disciplinary histories and arbitration awards.

More than 31,000 searches were conducted on BASIC last month alone. And because this information is available online, BASIC is a service that is utilized on an international level. I can honestly say that I don't think this type of information sharing would have been possible without a strong working relationship between the industry's self-regulatory organization and it's statutory regulator.

By the way, we are currently working on enhancements to BASIC that will expand the system to the international arena and make the system even more user-friendly. We are also working on a new project called the International Regulators Alert System. My colleague, Derek West, will give you more details on that project in a few minutes.

Organizations like the CFTC also play a valuable role in the sharing of information by conducting international symposiums like this one, where we can all exchange ideas and experiences with our fellow regulators and other industry professionals. The CFTC has also been instrumental in developing memoranda of understanding, or MOUs, with regulatory agencies around the world, ensuring that information will be shared across borders on a timely basis.

I mentioned at the beginning of this presentation that NFA President Bob Wilmouth is in Rome, discussing the issue of trading halts with other members of IOSCO. Bob is the chairman of the SRO Consultative Committee of IOSCO. The Committee is comprised of 52 IOSCO affiliate members, representing securities and derivatives markets as well as other self-regulatory organizations in developed and emerging markets. Bob has worked tirelessly for the past several years to convince international regulators of the importance of self-regulation, and we now have real progress to report.

The SRO Consultative Committee has designated liaisons with IOSCO's Standing Committees. These liaisons will attend Committee meetings, provide feedback and input on preliminary project workplans and draft papers before they are finalized, and collect self-regulatory and industry input and data when requested. This cooperation between IOSCO's Standing Committees and the SRO Consultative Committee will result in more comprehensive, timely projects that will benefit the entire international community.

As you can see, the relationship between self-regulators and statutory regulators can be a powerful and productive one. Industry input and representation contribute to a strong and effective compliance culture. Incorporating self-regulation into the regulatory regime can diminish the need for tax dollar financing and allow SROs and government regulators to avoid duplicating activities. SROs possess the flexibility to adapt to the regulatory requirements of a rapidly changing business environment. And information sharing between and among all industry participants strengthens the integrity of the marketplace, which benefits all of us.

My final point to you today is that, like all relationships, the relationship between a self-regulatory organization and its statutory regulator needs constant nurturing. We must keep the lines of communication open and listen to each other's concerns. We must know when to push our agenda forward and when to compromise graciously. And we must always look for new and innovative ways to meet the needs of the industry we regulate. This is an industry that is undergoing exciting and dramatic changes. Working together, we can meet the challenges of the future and ensure that we will weather whatever storms the financial services industry may face in the years ahead.

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